North Korea Risk Could Impact South Korean FDI: Citi

China places troops on heightened alert as threats from North Korea increase

North Korea’s fatboy dictator is now upping his threats of war on a regular basis. Citi is out with a new report on North Korea’s past provocative actions and how it has impacted South Korean stocks, FX, and FDI. Indeed, some believe that North Korea’s goal is to harm the South Korean economy.

North Korea is “winning in an asymmetrical psychological warfare,” Tom Coyner, a member of the American Chamber of Commerce in Korea and author of “Doing Business in Korea,” told The New York Times, “[by] attacking the economic strength of South Korea.”

Citi Research shows that the FX markets and FDI get hit worse than South Korean equities when tensions rise on the Peninsula Below are some of the key points from the Citi report:

Looking at 17 past North Korea shocks since 1996, Citi found that the FX market is more sensitive to the shocks, while KOSPI and KTB’s are less sensitive. For example, out of 17 cases, KRW weakened in 11 cases on the day of the incident, and USD/KRW fell by 0.5%, which is 5.3 KRW per USD on average. Meanwhile, KOSPI and 3yr KTB yield had declined 8 times out of 17 cases. For the 8 cases, KOSPI fell by 0.3% while 3yr KTB yield inched down by 2.5bps.

Those negative shocks have usually dissipated in a few days, but KOSPI has taken longer to return to previous level on average, around 2 weeks. Market responses differ on account of the nature of the shocks. The first and second nuclear tests were the strongest, since they had impacted all three markets; the recent third test hit the KOSPI and KTB market. On the other hand, the Yellow Sea incidents influenced only FX and KTB markets, while the Yeonpyeong bombing impacted KOSPI and FX markets alone.

Despite the inconsistent response of the markets to North Korea belligerence, any shock in and of itself is concerning and negative to sentiment. Recent weakness of KRW in part reflects this geopolitical risk. A weak KRW is definitely positive for Korean exporters amid heightened concern on weak JPY, but weak KRW could also increase inflationary pressures via import price increases in the later part of this year. If North Korea risk levels up the annual average of USD/KRW to 1,150 from Citi’s current forecast of 1,081, this could increase exports by around 1%p and economic growth 0.2%p while inflation could rise by 0.3%p.

North Korea risk could impact foreign direct investment (FDI) in South Korea

When the North Korea risk heightened in 2009 and 2010, following the second nuclear test and the sinking of Cheonan, foreign direct investment contracted by around 20% in YoY terms. However, those contractions could also reflect the impacts of lukewarm global growth and risks in the euro area. In 2011 and 2012, FDI had rebounded by growing 21.5% and 57.8%, respectively. In 2012, foreign direct investment registered a record-high $16.3bn despite the two North Korea long-range missile tests.

Is North Korea the new Iran of geopolitical risk? Citi believes North Korea has overtaken Iran as the year’s biggest potential flashpoint.

The current imbroglio highlights the current state-of-play in Asian geopolitics. The stakes have increased markedly since the last period of heightened tensions in 2010, as have many of the players. Most notably, there’s new leadership in China, a more muscular Japanese foreign policy , and a United States rapidly realigning security and trade relationships with its Asian partners, not to mention a new 20-something leader in Pyongyang. With this in mind, developments on the Korean Peninsula bear close attention. By comparison, even as Iran’s nuclear program continues to raise international concern, the P5+1 process means that efforts toward high-level diplomacy are ongoing, containing the risks.